The Great Burrito Arbitrage of 2006

I want to start this with a big "caveat emptor", this idea seems too good to be true, but after a day with some of my smartest friends working on it, we can't figure out why it won't work.

With that being said:

McDonalds is spinning off its 82% ownership of Chipotle. The way they are going to do it is through offering McDonalds shareholders the opportunity to exchange their MCD shares for "B" shares of Chipotle.

The new "B" shares will have the same economic interest in Chipotle as the "A" shares that began trading earlier in the year. However, the new "B" shares will have 10 times the voting rights of the "A" shares, so the "B" shares control the company. Since the "B"s have the same economic interest and a much larger control share, the "B" shares should be worth more than the "A" shares.

The exchange rate is set based on a two part formula. Based on this morning's (10/4/06) price, MCD investors can exchange each share of MCD for .88 Chipotle "B" shares. This implies a price of approximately $43 for each "B" share. Depending on the broker investors use, they must decide if they will exchange their MCD shares for the new "B" shares sometime between this morning and the end of business on Thursday (10/5/06).

This morning, CMG "A" shares are trading for approximately $49 per share.

I haven't done enough work to tell you what I think a share of Chipotle is worth, I don't know if the new "B" shares are really worth $43, $49, $25, or $369, I just haven't done the valuation.

Here is what I do believe: there is no way "A" shares should be worth more than "B" shares. Today there is an implied difference of $6 per share. This appears to be a classic arbitrage opportunity. To profit, investors should consider buying X # of shares of MCD (as long as your broker will still allow you to tender those shares) and sell short .88 X # of CMG.

Depending on how many people want to buy "B" shares when they begin trading, and how many people try to sell them to make a quick gain when they start trading, the price could be much higher, or much lower than the implied $43 price. However, if the "B" go up, the "A"s should go up by less, and if the "B"s go down, the "A"s should drop further.

Regardless of what direction prices move, the "B" discount should be reduced, and eventually eliminated.

There are some concerns about managing the arbitrage if the tender offer is over subscribed (if more MCD investors want Chipotle than there are Chipotle shares).

This should generate $6 in profit for investors who short CMG and tender MCD shares. It is possible that just tendering MCD and owning the "B"s could generate bigger profits, but going long "B"s exposes investors to the risk that "B" shares could lose value, if the investor shorts CMG they are only exposed to the risk that the discount gets wider rather than tightening, which seems unlikely.

Timothy Burger
timothyb(at)timothyburger.com